defense acquisition university

INCENTIVE

CONTRACTING

Tom Mann

Procurement Analyst
Pricing Specialist
SAF/AQCP

Presentation Defined

"An overview of various contract tools that can
be implemented to incentivize our contractors in
cost, schedule, and performance . Developing
tools to incentivize all three legs of this stool is
difficult. This session also includes an
explanation and discussion of contract geometry
of incentive arrangements."

Def: Incentive - [L. incentivus, fr. incinere to
strike up or set the tune, fr. In-+ canere. to singl
1. Inciting; stimulative 2. That which incites, or
tends to incite, to determination or action;
motive; spur

STEP 1 - DO YOU BELONG HERE?

Index

Types of Incentives
Multiple Incentives
Cost Incentive Contracts

3 Ways to Develop Contract
Geometry

Pitfalls Associated with an Incentive
Contract

My Lessons Learned
Cost Incentive Take Aways

Types of Incentives

Performance Incentive

- Product Characteristic
(Range/Speed/Thrust)

- Technical Performance (Overall
performance of end item)

Delivery Incentive (Improve from
Required Schedule
Cost Incentive (Manage Cost) *
Multiple-Incentive *

Other

Multiple Incentives

What Are They?

What Are They For?

How Do They Work?

Example

Graphs

Take Aways

Multiple Incentives - What Are

They?

Incentives Involving Schedule,
Performance, Cost Control - Three Legs
of the Stool
Combination of

- Motivation (Tech Progress, Timely Deliv,
Effect Cost Control

- Ultimate Objective (Balance between 3 Legs)
Basic Elements - Cost Incentive,
Increased/Decreased Fee/Profit,

Balanced Incentive Structure

Multiple Incentives - What Are
They For?

Attain Appropriate Balance
between the 3 Legs of the Stool

Quantitatively relate Profit
Motivation with Government
Objectives

Cost Incentive drives Minimum
Acceptable Performance : Multiple
Incentive - Maybe/Maybe Not -
best combination

Multiple Incentives - How Do
They Work?

6 Steps

- Select Parameters (Cost Must Be One)

- Establish Optimistic, Pessimistic, Target
Outcomes for Non-Cost Performance
Parameters

* Optimistic - Achievable and Of Value to Gov’t

* Pessimistic - Acceptable to Gov't

- Estimate Target Cost and Target Fee/Profit

- Estimate Optimistic/Pessimistic Cost Outcomes

- Establish Fee Pool

- Establish Relative Importance of Incentivized
Parameters

Multiple Incentives - Example

Cost Structure (CPIF)

- Target Cost = 120

- Target Fee = 10

- Max Fee = 18 (10 + 4 + 2 + 2)

- Minimum Fee = 2 (10 - 4 - 2 - 2)

- Share 80/20

- Fee Swing = +-8

Performance (Payload)

- Range 40k (MP), 50k (T), 60k (MO) +- $2M

Delivery

- Range 40 Mos (MP), 36 Mos (T), 32 Mos (MO) +-
$2M

ProtfP/Fe

Multiple Incentives - Graphing

6 0
Delivery (Mos)

"Goalposting the
Incentives"

& Target

Multiple Incentives - Examples

• Program 1 CPOIF - Fixed 2%, Event 1 - 2%, Event
2 - 2%, Initial Performance Eval 3%, Event 4 - 2%
- 7 pages tables, interim evals, mixes schedule
with tech perf, cost interims uses CPR data

• Program 2 - Cost Incentive 6% - Performance 4%
(all or none), 2% other

• Program 3 - Fixed 3%, 7% cost/sched/tech
incentive (all or none)

• Program 4 - 3% min/5% max cost (70/30), 9%
delivery key milestones (6 at 1%, 1 at 3%), 6 yr
failure period 5 critical functions, up to 10%
repayment

Multiple Incentives - Take
Aways

Know What Behavior You Want
Know What Behavior You Will Drive

Analyze Potential Trade-offs - Want
Balance

Keep Simple - Assessment Can Be
Difficult

Detailed information in DoD/NASA
Incentive Guide, Army Guide, Navy
Guide, etc.

Cost Incentive Contracts

* Types

* Uses

* Descriptions
9 Elements

* Central Theme

* Quick Refresher

Cost Incentive Contracts

- Types

Fixed-Price Incentive (F??)

Fixed-Price Incentive (Successive Targets)
Fixed-Price with Award Fee

- No Objective Measurement

- Award Fee in Addition to F&R Profit

- Exceed Satisfactory Performance
Cost-Plus-Incentive-Fee
Cost-Plus-Award-Fee

- Base Fee Fixed

- Motivate Excellence Quality, Timeliness, Technical
Ingenuity, Cost Effective Mgt

- No Trade Offs at Expense of Min Reqts

Cost Incentive Contracts - Uses

* Purpose: Incentivize Cost Control

* Result: Influence Behavior

* Establishes Profit/Fee formula

9 Share Ratio is always meaningful

* FPIF and CPIF are "Cost Type"
Contracts

Cost Incentive Contracts -
Descriptions

Fixed-Price Incentive Firm (FPIF)

Fixed-Price Incentive - Successive Targets (FPIS)
Fixed-Price with Award Fee (FPAF)

- No Objective Measurement

- Award Fee in Addition to F&R Profit

- Exceed Satisfactory Performance
Cost-Plus-Incentive-Fee (CPIF)
Cost-Plus-Award-Fee (CPAF)

- Base Fee Fixed

- Motivate Excellence Quality, Timeliness, Technical
Ingenuity, Cost Effective Mgt

- No Trade Offs at Expense of Min Reqts

Cost Incentive Contracts -
Elements

Fixed-Price Incentive Firm

- Target Cost $

- Target Profit $

- Contractor Share % for both Under and Over Target

- Ceiling $ Amount

Cost Plus Incentive Fee

- Target Cost $

- Target Fee $

- Contractor Share (cents/dollar) for both Under and
Over Target

- Max Fee (% of target cost)

- Min Fee (% of target cost)

Central Theme

Emperor Napoleon Bonaparte
said M Un bon croquis vaut mieux
qu'un long discours"

"A good sketch is better than a
long speech"

□ □□□□□

One Picture is Worth 10,000
Words

Quick Refresher

How to Draw the Graph
Graphing an FPIF
What Is PTA?

Name that Contract Type
Range of Incentive Effectiveness
Another Test
Graphing Matters

How to Draw the Graph

Plot Targ Cost and Profit/Fee
Plot An Underrun Point

Calculate PTA COST ((Big # - Next
Big #)/ Gov't Share) - Next Big#

Plot PTA point (Calc PTA cost,
Derived PTA Profit)

Connect the Dots
Plot Ceiling

Connect the Remaining Dots

Graphing an FPIF

Target Cost =
Target Profit =
Share Ratio =
80/20

Ceiling = 130

100
= 10

Cost $

COST PLUS INCENTIVE FEE
GRAPHICS/GEOMETRY

I I I I I I

COST PLUS INCENTIVE FEE (CPIF)

instructions for using this Model:

-ONLY change the cells that have BLACK colored font. DO NOT change the formulas in the cells that
have WHrTE colored font

-If you want to change the numbers/fonriat of the axis in the graph, either RIGNT click on the axis and
select "Format Axis" or click on the chart itself and use the Chart wizard by clicking on the icon for
"Format Axis."

-Make sure to SAVE the changes vou have made.

FIXED PRICE INCENTIVE FIRM
GRAPHICS/GEOMETRY

What Is PTA?

Point (Actually a Cost) of Total

Assumption

Maximum Price Paid by

Government

Elbow of Graph

Intersection of Share line past Targ
Cost with the 0/100 line prior to
Ceiling

((CP - TP)/GS) + TC = PTA Cost
Where cost risk entirely on
Contractor

Where contract becomes FFP

24

PTA Formulas

PTAc = ((CP - TP)/GS) + TC
CP = PTAc + PTAp
GS + CS = 100
GS = ( C P-TP)/( PTAc-TC )

PTAp = (PTAc-TC)(l-CS)+TP-PTAc
PTAp = TP-CS(PTAc-TC)

PTAp = CP - PTAc

CS = (TP - PTAp)/PTAc-TC

And on and on and on and on

Profit/Fee Profit/Fee

NAME THAT CONTRACT TYPE

Cost $

Cost $

NAME THAT CONTRACT TYPE (Cont.l

12

10

0 ) 8

U.

I 6

£ 4

CL O

2

0 ] T T 1

78.6 100 121.4 142.8

Cost $

Cost $

Range of Incentive
Effectiveness

Computed from Target Cost, Optimistic
Cost (Low Cost Estimate - LCE), and
Pessimistic Cost (High Cost Estimate -
HCE)

Area of Cost

- Incentive Meaningful

- FPIF : from PTA to Target Cost then to Approx
Equal Distance Underrun

- CPIF : from Max Fee elbow to Min Fee elbow
Critical Component for O/P/TC
Methodology

Another Test

DESCRIBE GRAPH

- 158 cost, 16 profit, 60/40 share, 198 ceiling
(125%)

- 298 cost, 30 profit, 70/30 share, 400 ceiling
(135%)

- 515 cost, 60 profit, 80/20 share, 671 ceiling
(130%)

- 400 cost, 60 profit, 75/25 share, 460 ceiling
(115%)

Avoid Embarassment - Know what you
got

Profit/Fe Profit/Fe

Graphing Matters

Target

Cost

3 Ways to Develop Contract
Geometry

Optimistic, Pessimistic and
Target Cost (OPTC) Methodology

- Example

- Graphs

Worm Analysis Methodology

- Examples

Logical Structure Methodology

Optimistic. Pessimistic
and Target Cost (OPTO

Establishes .Methodolog y.

Compute Target Cost, Target Profit/Fee, LCE, HCE
Can Be Used To Compute Share Ratio (FPIF/CPIF),
Min/Max fee (CPIF), Ceiling (FPIF)

Requires: Target Cost and Profit/Fee - cost
analysis - WGL - Fair and Reasonable
Compute Pessimistic - considered likely "worst
case" cost and a ppropriate profit/fee
Compute Optimistic - considered likely "best
case" cost and a ppropriate profit/fee
Pessimistic gives PTA (FPIF) or min fee (CPIF)
Optimistic gives max fee (CPIF)

Optimistic. Pessimistic
and Target Cost (OPTO

Opt NegPess Methodology

Material 95

110125

Material O/H 18

20

21

Engineering

24

30

35

Engineering O/H

4

5

6

Manufacturing

60

70

83

Manufacturing O/H

8

10

12

Other Charges

8

10

12

G & A

28

40

51

Cost Of Money

5

5

5

Total

250

300

350

OPTC Methodology -
Simple Example

Target Cost = 300 (through cost analysis)
Target Profit/Fee = 30 (through WGL)
Optimistic Cost = 250 (through adjusted
cost element analysis)

Pessimistic Cost = 350 (through adjusted
cost element analysis) - HAVE RIE
Optimistic Fee (Max for CPIF) = 45 (through
adjusted WGL)

Pessimistic Profit (PTA)/Fee (Min) = 15
(through adjusted WGL, 2-3% unallowables,
Fac Cap Emplyd, Worm Analysis, Other?)

Fee $

O/P CPIF Graph

Profit $

O/P FPIF Graph

Worm Analysis Methodology

• Computes PTA profit which then provides ceiling price given share
ratio, or share ratio given ceiling price

• Profit at PTA cost (0/100 SHARE, FFP STARTS, etc.), consists of
profit dollars without shared cost risk, should reflect a cost level
within the control of the contractor, and thus, would be the total
responsibility of the contractor

• The cost control and contract type factors from WGL consist of
those profit dollars associated with cost risk within the cost
incentive structure and whose risk we share - other factors are
considered the responsibility of the contractor and not unlike FFP

Profit at PTA = WGL Profit - cost control - contract type

Ceiling Price = PTA cost + PTA profit

PTA cost = Target cost + (Targ profit - PTA profit)

Contractor share

OR

Contractor Share = (Targ profit - PTA profit)/(PTA cost - Targ Cost)

Worm Analysis Methodology -
Simple Example #1

Target Cost = 300, Target (WGL) Profit
= 30

Cost Control = 7 and Contract Type = 3
Use PTAcost = Pess = 350 to Derive
Share

PTA Profit = 30 - 7 - 3 = 20
Ceiling = 370 (Pess 350 + PTApr 20)
Contractor Share = (30 - 20)/(350-300)
= .20

Worm Analysis Methodology -
Simple Example #2

Target Cost = 300, Target (WGL) Profit
= 30

Cost Control = 7 and Contract Type = 3
Use Share = 80/20 to Derive PTAcost
and Ceiling

PTA Profit = 30 - 7 - 3 = 20
PTA Cost = 300 + ((30 - 20)/.2) = 350
Ceiling Price = 370 (PTAcost 350 +
PTAprofit 20)

Logical Structure Methodolo

* Mixture of Worm + O/P, add dash of gut
logic, strain out some limitations

* Provides: Coordinated/Logical
cost/profit/share/ceiling at different risk
levels

* Requires: Weighted Guidelines assessment -
Note Contract Type Risk (FFP 2-4, FPIF/CPIF
0-2, CPFF 0-1 )

* Assures: Contract Type Characteristics Exist
- PTA

* Considers: Continuum Risk/RIE from Cost to
Fixed Type

Logical Structure Methodology

(cont)

Examples (assumes 1% COM):

- 85/15 share, 11% profit, 135% ceiling, PTA 81%

- 80/20 share, 11.5% profit, 131% ceiling, PTA 79%

- 75/25 share, 12% profit, 128% ceiling, PTA 77%

- 70/30 share, 12.5% profit, 125% ceiling, PTA 72%

- 65/35 share, 13% profit, 123% ceiling, PTA 68%

- 60/40 share, 13.5% profit, 122% ceiling, PTA 65%
Note: the more cost type - flatter share -
lower profit - higher ceiling - larger RIE
Note: the typical FPIF range within 2/3 to 3/4

Pitfalls Associated with an
Incentive Contract

Influence the Wrong Behavior

- Best for Gov't Not Always Obvious (Long
vs Short Term)

- Multiples - hurt one for another

Must have approved accounting system
Administration Cost

- Price Redetermination (audit, negotiation)

- Award Fee Tracking
Funding Not Certain

Requires Knowledge/Understanding

My Lessons Learned

"The Story": which is better deal

-Target Price 110, Share 80/20, Ceiling 130%

- Target Price 102, Share 80/20, Ceiling 144%

"Knowledge is Good"

Creativity

- Flat Spot

- Split Share

- Focus on ALL Elements
-Justify Line vs. Point
Changes Use Same Share

Cost Incentive Take
Aways

Contract Geometry is Somewhat Subjective
Assessment - More Art than Science
Maintain Arithmetic Logic of Contract Type
DRAW PICTURE!!!!

Cost Incentive Contract Allows Creativity

Range of Incentive Effectiveness Consideration

3 Methods Provided

Understand Behavior being Driven

Cost Incentive Contracts (FPIF,CPIF, FPIS) are

LINES

What the term PTA means
Thomas.Mann@wpafb.af.mil